Features of Basel I rules (Formerly adopted in 1988).

The accord/Agreement:

 Identified the principal types of capital acceptable to regulators (including core capital and
supplemental capital) and this was the first capital standard to account for risk exposure from
off-balance sheet transactions.

 Focused primarily on credit risk inherent in the bank balance sheet assets among off-balance
sheet items (such as derivative contracts and credit commitments), with market risk exposure
from changing interest rates, currency and commodity prices being added later.

 Determined individual bank capital requirements using the same formula and the same set of
risk weights (the ‘one size fits all’ approach).

 Applied the same minimum capital requirements to all banks.

Note:

a) The international capital standard permits subordinated debt with an original average maturity
of at least five years to count toward required Tier 2 capital.

b) The combine maximum amount of subordinated debt of intermediate-term preferred stock

qualifying as Tier 2 capital is limited to 50% of Tier 1 capital.

c) Allowances of loan and lease losses count as Tier 2 capital provided the loan loss reserves are
general (not specific) reserves and do not exceed 1.25% of RWAs.

d) The components of Tier 2 capital are subject to the discretion of bank regulations in each nation.

Ascertaining RWAs under Basel I. (Illustration).

Each asset item on a bank’s balance sheet and each of-balance sheet commitment it has made are
multiplied by a risk-weighting factor designed to reflect its credit exposure. The common off-balance
sheet items are stand-by LCs and legally binding credit commitments made by the banks to their
customers.

Suppose an international bank has $4,000 in Tier 1 capital, $2,000 in Tier 2 capital, $100,000 in total
assets and the following on and off-balance sheet items:

On-balance sheet items (Assets). $

 Cash 5,000

 U.S Treasury securities 20,000

 Deposit balances held at domestic banks 5,000

  Loans secured by first charges on residential properties 5,000

 Loans to private corporations 65,000

Total balance sheet assets. 100,000

Off-balance sheet items.

Stand by LCs backing municipal and corporate borrowing 10,000

Long term legally binding credit commitments-private companies 20,000

Total. 30,000

The weights given by the regulatory supervisor on each item in the bank’s portfolio are 0% for cash and
government securities, 20% for deposits held at other banks and certain stand-by credit letter, 50% for
home mortgage loans and 100% for corporate loans, long term credit commitments and al other claims
on the private sector as well as fixed assets.

Required.

Calculate the capital adequacy ratios under Basel I.

Suggested solution; Part of class work demonstrations.

Capital requirements attached to derivatives.

Subsequently, Basel I capital standards were adjusted to account for the risk exposure banks may face
from derivatives – futures, options, interest rate and currency swaps, interest rate cap and flow contracts
and other instruments used to hedge against changing currency prices, interest rates and positions in
commodities. These expose the bank to a counterparty risk i.e. the danger that a customer will fail to
pay or to perform, forcing the bank to find a replacement contract with another party that may be less
satisfactory. Bankers are required to;

 Convert each risk exposed contract into its CEA as if it were a risky asset listed in the balance
sheet.

 Multiply this CEA by a pre-specified risk weight (See table of risk weights).

 Divide each contract’s risk into potential market risk exposure (danger of loss at some future
time) and current market risk exposure (The risk of loss if the customer defaults today
compelling the bank to replace the failed contract with a new one).

 Determine the market value of a contract that is similar to the one made with the customer so
as to figure out its replacement cost. Time value of money is put into play while considering any
future cash flows.
Once the replacement cost of a contract is obtained, the estimated potential market risk is added to the
estimated current market exposure risk to get the total CEA of each derivative contract which is then
multiplied by the correct risk weight to find the equivalent amount of RWAs represented by each
contract.